by Tim Gaumer.
The history of roll-ups is a checkered one. Roll-up is the colloquial term given by investors to a company that consolidates an industry by a large number of acquisitions, rolling them up under a parent company. According to a September 2008 Harvard Business Review article authored by Paul Carroll and Chunka Mui, more than two-thirds of roll-ups have failed to create any value for investors. Let’s analyze a current example.
Steinhoff International Holdings NV, a Dutch public company listed in both Johannesburg (SNHJ.J) and Frankfurt (SNHG.DE), has assembled a collection of 40 brands in 30 countries — UK-based discount retailer Poundland, U.S. retailer Mattress Firm (itself a combination of former competitors Sleepy’s, Mattress Discounters and Sleep Train), Snooze and Freedom in Australia, and Russells, Pep and Ackermans in South Africa.
Some of the biggest accounting disasters in history were also roll-ups: MCI WorldCom, Enron, and Tyco come to mind. On Dec. 6, Steinhoff announced it was delaying the release of its financial statements after auditor Deloitte declined to sign off on them. With that announcement, Steinhoff management announced it had retained PwC to conduct an investigation. The result of that investigation was an admission that 2016 results would be restated. Later, the company disclosed that financial results from 2015 would also require restating and likely for prior years.
Although it’s anyone’s guess how severe the restatements may be, phrases such as “accounting irregularities” are met by large stock price declines. Since its announcement in early December, Steinhoff’s shares have lost nearly 90% of their value, as shown in Exhibit 1.
The company has said it’s in talks with creditors about a financial restructuring. In a meeting with bankers, the company disclosed that total group debt stands at EUR 10.7 billion (Thomson Reuters StreetEvents Transcript, December 19, 2017). Liquidity may becoming an issue – the company has put up for sale a Gulfstream jet it bought in 2016. Exhibit 2 shows the bond market’s reaction. The company’s 1.25% Oct 2023 convertible bond issued by its Steinhoff Finance Holding GMBH unit is now trading at 49 cents on the euro.
Its CEO left the company along with other members of management, but oddly, CFO Ben La Grange retained his job. However, it was recently announced that he would relinquish his role as CFO to focus on corporate liquidity.
Exhibit 1: Steinhoff 3-Month Stock Price History
Exhibit 2: Steinhoff 6-Month Convertible Bond Price History
Early Warning Signs
Hindsight is always 20/20, but the Refinitiv StarMine quantitative analytics were waving a few red flags well before the company’s accounting irregularities were announced. Take a look at the StarMine Earnings Quality (EQ) model. We’ll admit that it’s somewhat difficult to make reference to analytics that use only historical financial filings data once the accuracy of that data has been admitted by the company to be unreliable. However, it’s probably reasonable to assume that whatever “irregularities” existed would have made results look better, not worse, than they will after the restatements.
Exhibit 3 shows the company’s EQ score history over that last two years (blue line). It has been low throughout this period, but declined to a bottom decile rank in late 2016 and stayed there for nearly all of 2017. A bottom decile score represents the lowest 10% of all companies in its geographical region (Emerging Markets in this case).
Exhibit 3: StarMine Earnings Quality Model Score 2-year History
Exhibit 4 shows the EQ model components and subcomponents. The model is designed to disaggregate earnings into their sustainable and unsustainable sources and builds upon the Accruals Anomaly (Sloan, et. al.), accruals being the unsustainable source of earnings.
Steinhoff currently receives a score of 14 out of a possible 100 with high scores being the best. Hurting its score is the Accruals Component with its score of 22 and Operating Efficiency at 29. A major contributor to the low Accruals score is the large increase in Other Non-Current Assets. That category includes goodwill and intangibles and reflects the acquisitive nature of the company. Other Non-Current Assets increased 38.7% as a percentage of average net operating assets from June 2016 to March 2017. In May 2016, the company changed its fiscal year-end from June to September.
Exhibit 4: StarMine Earnings Quality Model and its Components
Cash flow issues
Exhibit 5 compares cash flow from operations to reported net income. The green portion of the bar chart shows the amount by which cash flows exceed net income. The red portion show periods in which cash flow lagged net income. During the past 10 years, the deficit was never larger than in the period ended March 2017. In that half-yearly period, the company reported net income of EUR 706 million and cash flow from operations of just EUR 13 million – the lowest level in the 10 years shown here. In other words, cash flow lagged net income by EUR 693 million.
Exhibit 5: Cash Flow from Operations vs. Net Income
Similar to Exhibit 5, Exhibit 6 compares cash flow to net income. But in this chart, it displays free cash flow instead of cash flow from operations. During the March 2017 interim period, free cash flow (FCF) was negative EUR 403 million compared to net income of EUR 706 million. This was the largest cash outflow of any period over the last 10 years. In the roughly comparable six month period of 2016, ended June, FCF was a positive EUR 164 million vs. net income of EUR 533 MM.
Exhibit 6: Free Cash Flow vs. Net Income
Declining operating efficiency
Besides accruals and cash flow, operating efficiency represents the third component of the Earnings Quality model. Companies with higher returns also tend to have more sustainable earnings. Exhibit 7 shows Steinhoff’s return on net operating assets in blue compared to the consumer discretionary sector, of which it’s a member, in gold. Except in the June 2008 period, when both its and the sector median was 15.7%, Steinhoff has consistently lagged the returns generated by the sector as a whole. Its returns have sagged over the years and is now just 5.6%.
Exhibit 7: Return on Net Operating Assets
A return on assets ratio can be decomposed into the product of profit margin and asset turnover. In the case of Steinhoff, its asset turnover has been the biggest drag on returns. As Exhibit 8 shows, it is well below the sector median and is now near its low point of the last 10 years. Steinhoff’s asset turnover rate was just 0.61 during the last half-year period reported.
Exhibit 8: Asset Turnover
Neither the Earnings Quality model, nor any of the other predictive analysts under the Refinitiv StarMine brand are or were designed to be fraud detectors or a signal of aggressive or otherwise flawed accounting measures. However, StarMine analytics will provide a source of insight into poor or deteriorating financial fundamentals, such as cash flows, operating efficiency, accounts receivable build-up and other accrued earnings.
This has long been a useful tool, but it may be especially so today. With most global markets on the expensive side, disappointments are severely punished. Avoiding them may be another source of alpha. You can generate alpha by picking more winning stocks. You can also generate alpha by avoiding the losers.